INDUCED: The general notion that changes in one variable are related to, or caused by, changes in another variable. Induced relations, especially changes in consumption expenditures are induced by changes in disposable income, are a key aspect of Keynesian economics and the multiplier effect. The alternative to an induced relation between variables is an autonomous relation, in which one variable is not related to another.

A medium of exchange (money) with value in exchange, but little or no value in use. Modern paper currency, coins, and checkable deposits are fiat money. The value of fiat money comes from the public's general willingness to accept it in exchange for other goods. This willingness comes from the fact that EVERYONE is willing to accept fiat money in exchange, which largely depends on the public's confidence in the authority (usually government) issuing the fiat money. Fiat money is NOT valuable unto itself, but it is valuable for what it can buy. In the march toward economic complexity, fiat money emerged from commodity money, money with both value in exchange and value in use.

Fiat money emerged from commodity money when people realized that value in use was NOT a requirement for a medium of exchange. Moving away from money with value in use made it possible to use items that better fit the durability, divisibility, transportability, and noncounterfeitability characteristics of money.

Most important to modern economies, fiat money is more easily controlled by the issuing authority, which gives rise to active use of monetary policy to control business-cycle instability. It also avoids unpredictable and uncontrollable fluctuations in the value of commodity money, which can wreck havoc on the economy, that result from market shocks of the commodity.

Money by Decree

The "fiat" part of fiat money means an arbitrary order or decree, such as what government might enact. This means that fiat money has value as money simply because government says so. Government issues an order, decree, or law stating that fiat money is valuable. Period.

But, can this really work? Consider how many people regularly violate other government laws and decrees. How many people regularly violate traffic laws?

It works when government decrees that people can use fiat money to pay their taxes. Any item that is accepted by government for tax payments is well on its way to being the generally accepted medium of exchange.

Two Values

The two types of value that are important for understanding fiat money (and which differentiate it from commodity money) are value in use and value in exchange.

Value in Use: This means that the satisfaction of wants and needs is provided by the direct consumption of goods and services. Acquiring value from the use of goods and services is really the ultimate goal of economic activity. It is the final step in the production, allocation, and consumption activities that are undertaken to address the fundamental problem of scarcity.

Value in Exchange: This means that an item, especially money, can be traded for other goods and services that can then be used to satisfy wants and needs. Value in exchange means that value, that is satisfaction, is obtained indirectly through the acquisition of something else. For an item to have value in exchange it need NOT have value in use.

Fiat money has value in exchange, but little or no value in use. In contrast, commodity money has both value in use (the commodity part) and value in exchange (the money part).

The Emergence of Fiat Money

In retrospect, the transition from commodity money to fiat money seems obvious, a logical next step in the historical progression that moved from self-sufficiency to barter to commodity money. However, the separation of value in exchange from value in use was a major conceptual breakthrough that made continued economic progress possible. Humans made the transition from commodity money to fiat money in three steps:

Fully Backed Paper Currency: The first step was to issue paper currency that was backed completely by the commodity money, which at this stage of development was usually gold or silver. In principle, this paper currency could have been traded for equivalent amounts of gold or silver, which was prudently stashed away in a secure location. The United States, for example, issued gold and silver certificates backed by actual amounts gold and silver stored in large vaults. However, because the paper currency generally fit the money characteristics better than the metals, especially transportability, the public took to using paper currency over the actual commodity (metal) money.

Paper Currency Exchange Rate: The second step was the realization by the money issuers that very few people actually traded paper currency for commodity money, that very few people actually used gold or silver as money. The public willingly used paper currency as THE medium of exchange. This meant that the money issuers did not need to maintain an exact equality between the amount of the commodity money stashed away and the amount of paper money in circulation. They could have, for example, $10 billion worth of paper currency, backed by only $1 billion worth of gold. In essence, all they really needed was an exchange ratio between the paper currency and the commodity money. That is, they could FIX the price of gold at $35 an ounce and the price of silver at $1 an ounce. If anyone wanted to redeem their paper currency for gold or silver, which few people did, they could have done so at these fixed prices.

Fiat Paper Currency: The third step to full-fledged fiat money was easy once people grew comfortable using paper currency rather than the actual gold or silver commodity money. The money issuing authorities simply stopped fixing the price of the commodity money. Disconnecting the price of the commodity from the value of the fiat paper currency meant that the money was no longer backed by the commodity money, by the gold or silver. What it did mean was that the paper currency was valuable based on its general acceptability, based on its ability to purchase goods, based on the decree of government. This also made it easier for the money issuing authority to control the total of amount of money in circulation.

Modern Fiat Money

While paper currency was the first type of fiat money widely used, and remains the most obvious example, modern fiat money comes in four basic varieties: paper currency, metal coins, checking accounts, and electronic money.

Paper Currency: This consists of pieces of paper, generally issue by a government authority, with an established monetary denomination. The United States, for example, has $1, $5, $10, $20, $50, and $100 bills issued by the Federal Reserve System. In the past, paper currency was also issued by the U.S. Department of Treasury, some state governments, and more than a few private banks. Paper currency is fiat money because the value in use of the commodity, the paper, is but a small fraction of the value in exchange of the currency.

Metal Coins: This includes shiny metal discs made from relatively inexpensive metals and metal alloys. While metal coins have been around for centuries and were a key component of commodity money, modern use of metals for coins predominately results in fiat money. The reason is that the value of the metals used in the coins is substantially less than the face value of the coins.

Checking Accounts: The most common type of fiat money in modern economies is checking accounts, or more precisely checking account balances maintained by banks. Checking account money is a two-part system, consisting of the bank accounts and the paper checks used to access the funds in those accounts. For the most part, checking account balances are merely accounting entries in a bank's computer database. The energy used to store this information (that is, keep the computer running) has significantly less value in use that the value in exchange of the funds in the bank accounts. Likewise, the paper checks used to access the account balances are also less valuable than what the balances can buy.

Electronic Money: This fourth type of fiat money is the emerging use of electronic bank account balances without the use of paper checks. These balances are accessed directly through debit cards, ATM machines, and store computers. While this electronic money is "officially" included as part of checking account balances, advances in computer technology are quickly transforming this into a unique type of fiat money.

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